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Friday, October 26, 2007

Asset Bubbles... and Monetary Policy

There was an interesting article this past week from Daniel Gros who reminded us that the boom-bust cycle in the U.S. housing market is not unique. Rather, there are also "House Price Bubbles Made in Europe." Here is a figure from his paper that compares real housing prices in the Euro area and the U.S. through 2006:

It is interesting how real housing prices in the Euro area follow a similar pattern to the U.S. real housing, albeit with a lag. As JMK has noted in the comment sections of this blog, this common movement in real housing prices means my often-expressed past monetary profligacy view (here, here, here, and here) cannot be the whole story. Financial innovation, low financial literacy, predatory lending, and excess saving from other parts of the world are meaningful contributors too. Nonetheless, the macroeconomist in me has a hard time believing these factors as being completely independent of--or as consequential as--loose monetary policy in advanced economies coupled with boom psychology.

To illustrate my point here is a figure (click here for a larger file) from one of my working papers:

The first graph in the figure plots the year-on-year growth rate of quarterly world real GDP against a weighted average G-5 short-term real interest rate. The quarterly world real GDP series is constructed by taking the quarterly real GDP series for the OECD area and using it with the Denton method to interpolate the IMF’s annual real world GDP series. This figure reveals that just as the global economy began to experience the rapid growth in the early 2000s, the G-5 short-term real interest rate turned negative as monetary authorities in these countries eased monetary policy. This positive G-5 interest rate gap—the difference between the world real GDP growth rate and the G-5 short term real interest—narrowed as the short-term real interest picked up in 2005, but it still fell notably short of the world real GDP growth rate by the end of 2006. Two measures of global liquidity corroborate the easing seen by the positive G-5 interest rate gap. The first measure is a ratio comprised of the widely used ‘total global liquidity’ metric, which is the sum of the U.S. monetary base and total international foreign reserves, to world real GDP. The second measure is a ratio comprised of a G-5 narrow money measure, which is the sum of the G-5’s M1 money supply measures, to world real GDP. Both measures show above trend growth beginning in the early 2000s. The bottom panel of Figure 5 shows some of the consequences of this global liquidity glut: real housing prices soar in the United States and United Kingdom and are systematically related to the positive G-5 interest gap. (I would love to get Daniel Gros' real housing price index for the Euro area and run a scatterplot of it too)

So in the end I am stuck on the view that loose monetary policy (in conjunction with boom psychology) was very important to the housing boom-bust cycle of the past few years.